Federal Reserve chairman Alan Greenspan has been widely criticized for claiming in his August 30 address at Jackson Hole, Wyoming, that the Fed is not at fault for failing to deflate the U.S. stock market bubble. Specifically, Greenspan, who was addressing the Federal Reserve Bank of Kansas City Symposium on Rethinking Stabilization Policy, asserted that an interest rate increase sufficient to deflate the bubble would have done significant damage to the economy at large: "The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion."

Chairman Greenspan raised an important issue, suggesting that we need to understand better the role of equity risk premiums in asset bubbles, and he urged "productive discussion of these and other issues related to stabilization policy" at the symposium. In fact, little discussion followed, either of the causes of the late 1990s bubble or of the appropriate role of central banks in dealing with bubbles. Nor was additional insight on these difficult issues offered by critics who dismissed Chairman Greenspan's remarks as an ill-advised apologia for the Fed's role in addressing the stock market bubble.

Intervention and the Risky Asset Bubble

A close look at the role of governments in markets during the last half of the 1990s suggests that the Fed's role in creating preconditions for a stock market bubble was, at most, peripheral and that the Fed did undertake to cool an overheating economy in 1999. The fact that equity risk premiums, the expected higher total return on stocks above returns on "riskless" government bonds, were falling sharply while the U.S. equity market bubble was inflating suggests that the real contributor to the global bubble was the proactive role of policymakers in rescuing markets from the fallout of the Asian bubble in 1997-1998, including the Long-Term Capital Management crisis in October 1998. While the Fed played a subordinate role in all of these events, the proactive role of the U.S. Treasury and the International Monetary Fund was more decisive in creating a moral hazard problem that led global financial markets first to be shocked and driven from risk exposure by the Russian default and devaluation in August 1998 and then to be overly inured to risk after the rescue of Long-Term Capital Management in October 1998.

An understanding of the forces leading up to the U.S. equity market bubble during the late 1990s requires a careful examination of global economic conditions prior to its emergence. A good place to begin this story is with the collapse of the Mexican financial markets late in 1994, which was followed by an aggressive IMF-led and U.S. Treasury-sponsored rescue for Mexico early in 1995. The Mexican rescue, widely hailed at the time as a great success, established the model whereby the U.S. Treasury and the IMF worked in tandem to ensure financial stability in emerging markets.

During the following two years, a speculative bubble developed in Asia where the emerging markets of Thailand, Indonesia, Korea, and Taiwan had come to be seen as economies with unlimited upside potential. Capital flowed rapidly to the region and a speculative bubble developed in real estate and a variety of other investment types. Strains began to show in 1997 as widespread signs of excess capacity emerged.

Simultaneously in the United States, records of Fed meetings show that some Fed governors, including Lawrence Lindsey, had begun to raise concerns about the rapid increases in U.S. equity prices. In September 1996, the Fed held lengthy discussions internally concerning possible speculative excesses in U.S. equity markets. Chairman Greenspan's December 1996 reference to the possibility of "irrational exuberance" was an external reflection of those discussions, even though in his speech Greenspan linked irrational exuberance to the Japanese equity market bubble in the late 1980s. Even though most measures of fair value for stocks failed to show overpricing late in 1996 and early in 1997, the Fed was concerned enough to begin raising U.S. interest rates in March 1997, when it boosted the fed funds rate by twenty-five basis points to 5.5 percent.

Asian Crisis Invites Moral Hazard

The emergence of the Asian crisis late in the spring of 1997 marked the start of a period of financial instability that constrained Fed actions over the following two years and probably, thereby, contributed to the Fed's role in the eventual emergence of the 1999 U.S. equity market bubble. But the primary role was played by the U.S. Treasury and the IMF and their ever-increasing role in bailouts that ultimately failed to prevent either the Russian collapse or widespread devaluations in Asia and Latin America.

To understand the timing of the Asian collapse it is important to remember events in the largest Asian economy--Japan. The Japanese economy had, after 1995, experienced a recovery, including a resurgence of investment spending that appeared to place Japan on the path for a sustainable recovery. However, in April 1997, Japan implemented a sharp increase in its consumption tax and in payroll withholding taxes for retirement and health benefits. The negative impact on demand growth in Japan sharply weakened the Japanese economy and caused Japanese financial institutions to reduce their loan portfolios in Asia. Thailand was the weakest of the once booming Asian economies, and, when Japanese banks refused to roll over credit lines to Thailand late in the second quarter of 1997, the Asian crisis began to intensify.

The summer of 1997 saw intense denial that an Asian crisis was emerging. The September 1997 IMF meetings were largely devoted to empty testimony to the resilience of the region. Subsequently, during the fall of 1997, the Indonesian and Korean bubbles collapsed. Efforts to repair the damage with substantial Treasury-sponsored IMF rescue packages were not very successful. The Korean rescue package cobbled together late in 1997 failed at the end of the year.

Treasury Intervention and Moral Hazard

In January 1998, Treasury secretary Robert Rubin summoned leading global bankers to the boardroom of the New York Federal Reserve Bank and enlisted an additional $25 billion in aid for Korea to stem the then-burgeoning Asian crisis, thus solidifying the role of the U.S. Treasury and the IMF as a guarantor of global investors. There followed a powerful recovery in global financial markets during the first half of 1998 capped by a large bond issue for Russia, which was underwritten by Goldman Sachs in June 1998. Reassured that a proactive U.S. Treasury and IMF would not allow a nuclear power to default, investors celebrated by purchasing high-yielding Russian bonds. Unfortunately, the government in Russia failed to get the message and in August 1998 devalued the currency and defaulted on its obligations to global lenders.

Another event in June 1998 contributed to deflationary pressure in Asia. During the spring of 1998, the value of Japanese yen, the currency of a weakening economy in a weakening region, fell sharply. The consequent improvement in Japan's competitive trade position in Asia alarmed the Chinese, ever vigilant of their dominant role as an exporter within Asia. The Chinese insisted that the yen's depreciation be ended. The Chinese pressed their demands vigorously on the eve of a trip to China and Japan by then-President Bill Clinton and suggested that the Chinese visit would not go smoothly unless the United States took decisive measures to terminate the depreciation of the yen.

In mid-June of 1998, the U.S. Treasury directed the Federal Reserve to join the Japanese in selling dollars, thereby ending the drop in the yen and ultimately resulting in a period of yen appreciation that contributed substantially to the deflationary environment both in Japan and Asia overall. Once again, the proactive role of the U.S. Treasury was hailed as a reassuring event, but the deflationary implications for Japan and Asia of a stronger yen were largely unnoticed and then forgotten in the wake of the dismaying devaluation and default by the Russian government in mid-August.

Russian Default Kills Appetite for Risk

So unnerving was the Russian default, not only to the hapless holders of Russian bonds, many of which were purchased just two months earlier, but more broadly, to financial risk managers worldwide, that decisions were quickly made to reduce sharply the exposure of private financial institutions to global markets. After the proactive successful role played by the U.S. Treasury-IMF team in Latin America and Asia, the Russian default suggested bailout impotence. As a result, the spreads between emerging-market bonds and U.S. Treasuries and other indicators of risk exploded during September and early October as a flight to quality ensued. The world's largest volatility risk-spread trader--Long-Term Capital Management--which had huge bets that widening spreads between riskier assets and U.S. government securities would narrow--was wiped out by the flight to safety that caused those spreads to balloon.

Once again, in September 1998, the offices of the New York Federal Reserve Bank were offered to provide to private financial markets the implicit approval of the Fed and the U.S. Treasury of efforts to craft a rescue package that financial markets could not manage on their own. The decision to accommodate the rescue of Long-Term Capital Management (LTCM) was a difficult one. Clearly, financial markets were disrupted by the events leading up to the virtual collapse of LTCM. Numerous banks and investment banks were substantially exposed to financial risk, both through their direct involvement with LTCM and through the broad role that they played in what had become highly volatile financial markets.

The rescue of LTCM, or more accurately the reduction of the widespread exposure to LTCM's activities, was accompanied by rapid rate cuts by the Fed. The Federal funds rate was reduced by seventy-five basis points between the end of September and mid-November 1998 in what became part of a successful effort to restore more normal spreads and lower levels of volatility in financial markets.

LTCM Rescue Rebuilds Appetite for Risk

By the end of 1998, relative calm had been restored to global financial markets. More significantly, the confidence of markets that governments stood ready to intervene in cases of extreme financial stress was underscored. The feelings of abandonment that had arisen in global markets after the Russian default and devaluation were erased by the rescue of Long-Term Capital Management and the Fed's rapid rate cuts.

The year 1999 was the real bubble year in U.S. and global financial markets. The focus was on what might have been viewed as riskier stocks in the U.S. information and technology sector. As I wrote in the January 2000 Economic Outlook "How the Bubble Bursts," the "tech-craze phase of the stock market strengthened dramatically in the last weeks of 1999 . . . the NASDAQ Index, heavily weighted with high-tech stocks, has gone from being up 30 percent on the year in October to being up 80 percent on the year in late December." Emerging markets boomed as well with risky assets rising most rapidly. As Chairman Greenspan noted, the equity risk premium in the U.S. stock market fell, consistently with the idea that higher returns on risky assets were very attractive if governments, the IMF, and after October 1998, the Fed were prepared to underwrite additional risks.

Because conditions in 1999 were very good for financial markets and especially for riskier assets, a bubble developed, most dramatically affecting the shares of riskier companies in the information-technology sector. In the aftermath of the Asian bubble with its attendant excess capacity, cheaper raw materials were available for U.S. producers, including those in the high-tech sector. The Fed easing of seventy-five basis points, which had been induced by the LTCM crisis, provided a further tail wind, as did an additional flow of safe haven capital to the United States, which was newly anointed as the world economic champion. The cost of capital for tech ventures was pushed nearly to zero as dot-com shares were snapped up regardless of earnings or prospects for earnings. Excess capacity expanded rapidly.

By mid-1999, the party was heating up enough so that the Fed began to apply restrictive policy. From June 1999 through March 2000, it increased rates in twenty-five basis-point increments five times to 6 percent. In May 2000, it followed up with another fifty basis-point increase two months after the peak of the bubble and during a period of sideways movement of most stock market indices.

Bubble Bursts

While 1999 was the exhilarating bubble year for the U.S. and other global financial markets, the year 2000 saw the start of a period when the bubble became self-correcting as the underlying conditions supporting it melted away. By the fourth quarter of 2000, U.S. growth had dropped to 1.1 percent from an extraordinary 7.1 percent growth rate in the fourth quarter of 1999. The fourth quarter of 2000 also witnessed the first of what was to become a string of seven negative quarters of investment growth lasting through the second quarter of this year and perhaps beyond. Investment growth slowed because excess capacity had been generated by the costless capital available courtesy of the stock market bubble. Excess capacity meant falling prices for IT products whose stock price increases had been the greatest. Expected profits in the stock market began to fall sharply, and by December 2000 the NASDAQ's Index had been cut in half to just below 2,500 from its high of 5,000 in March.

The steep drop in the stock market was accompanied by an abrupt slowdown in United States economic growth driven largely by an inventory sell-off and continued falling investment spending. The U.S. entered a mild but unusual recession, with consumption sustained but investment very weak, early in 2001 and saw negative growth during the first three quarters of that year. As growth slowed and unemployment rose, the Fed cut rates rapidly beginning in January 2001 from 6.5 percent down to 3 percent by August. The sharp rise in uncertainty associated with the September 11 terrorist attacks on New York and Washington, D.C. led to another rapid sequence of cuts totaling 125 basis points between September 17 and December 11. The Fed has left the fed funds rate at 175 basis points during all of 2002. A consumption surge at the end of last year fueled by tax cuts and lower interest rates boosted growth to about 5 percent in the first quarter of 2002. However, by the second quarter, growth had slowed back to 1.1 percent, largely supported by modest inventory building.

The persistence of negative investment growth while most of the strength of the economy is confined to a credit-driven spending surge on autos and housing has left the Fed and most analysts uncertain as to the sustainability of growth in the future. While it does look as if a consumption rebound in the third quarter of this year could push growth to the 3 to 4 percent range, concerns persist that growth will fade again at year-end. The weak stock market reflects widespread concerns about the sustainability of profit growth along with a heightened sensitivity to the risks inherent in global equity markets.

Bubble Lessons

Looking back over the past half decade, it becomes clear that the global equity market bubble of 1999 was one of a series of bubbles that emerged in the last half of the 1990s. The proactive response of government, especially the U.S. Treasury and the IMF, along with the cooperation of the Federal Reserve, appeared by 1999 to have created a strong perception that aggressive investments in risky markets were more attractive than usual by virtue of the apparent willingness of the U.S. Treasury and the IMF to underwrite those risks, coupled with the willingness of the Fed to maintain an accommodative stance for monetary policy when such rescue efforts were underway. This classic moral hazard problem may have been responsible for the compression of risk premiums in U.S. equity markets that Chairman Greenspan mentioned in his Jackson Hole address. Certainly risk premiums in other risky investments, such as those for bonds of emerging markets, were also compressed during 1999.

The important question still facing the global economy is not so much who caused the bubble but, rather, whether stimulative monetary and fiscal policy can produce sustained economic growth and with it sustained growth in profits that will enable financial markets to recover as part of a credible resumption of global demand growth.

We remain in a global economic environment best described as a "post-bubble era," where investment spending drops sharply and then excess capacity and the need to preserve profit margins force down employment and consumption. That the Federal Reserve has confined itself (so far this year) to hoping for a recovery, while the European Central Bank perversely continues to believe that inflation is lurking just below the surface and the Bank of Japan has openly declared its impotence to do anything further to help the Japanese economy, is discomforting at best. If history is any guide, look for the aftermath of the bubble to display dismayingly consistent economic weakness that leads the Fed to resume interest rate cutting, probably by another seventy-five basis points over the balance of this year. Subsequent dollar depreciation may well force the European Central Bank to ease while the government of Japan is pressed to increase liquidity further.

John H. Makin is a resident scholar at AEI.